CSX Corporation Earnings Disappoint; Activists Push For Overhaul

On Wednesday, the Wall Street Journal broke the news that former Pershing Square Partner Paul Hilal was looking to recruit railroad veteran and Canadian Pacific CEO Hunter Harrison for a campaign to overhaul Florida-based CSX, just a few hours after the company had reported mildly disappointing earnings and Canadian Pacific Railroad announced Harrison’s long-expected departure date. Hilal, the Journal said, had raised $1 billion for a single investment – enough to buy a roughly 3% stake in CSX before Thursday’s rally on the back of the news.

CSX Corporation

Many readers will be familiar with the backstory, but for those who aren’t, Hilal was the analyst who saw that Canadian Pacific’s fundamentals were underperforming their potential, lured Harrison out of retirement to lead a dissident slate, won seven seats on the board after a proxy contest that shook corporate Canada and made more than $2 billion for Pershing Square’s investors (it could have been more had the fund sold its shares in September 2014 when they peaked at $214, rather than in August last year, when they hovered around $150 – all amounts in USD). A regular advocate for activism at Harvard University roundtables, he left Pershing Square around a year ago to pursue his own venture.

Harrison, who had been expected to retire for the second time, will now leave Canadian Pacific at the end of this month and is forfeiting CA$118 million in compensation from the company to pursue this opportunity. According to analysts who cover the sector, he has long held ambitions to bring his “precision railroading” philosophy, which involves dispatching locomotives at fixed times whether full or not to improve delivery speeds, to the “big leagues.” Indeed, as weak coal prices weighed on the whole industry in late 2015, Canadian Pacific tried to buy U.S. counterparts CSX and Norfolk Southern.

If history explains part of the rationale for this deal, the financials are less clear. CSX now trades at a price-to-earnings ratio of 24-times following the recent surge in the stock price, compared to 21-times for Norfolk Southern and 19-times for Kansas City Southern. Despite an 18% rally by midday Thursday, markets have so far largely shown their appreciation for what CSX has achieved in the face of difficult headwinds, Dave Vernon, an analyst at Bernstein, told me in an interview yesterday. CSX is unlikely to want Harrison in the boardroom or management suite and has apparently concluded his approach won’t work, he adds. If the company is forced to accommodate him anyway, the relationship could turn “toxic.”

Moreover, Vernon is skeptical that CSX can better the operating margins of its Western U.S. peers, given that railroad profitability is dependent on routes and historical investments, among other things. “Railroads are all different, and their margins shouldn’t necessarily be the same,” he says. Investors evidently feel they should in competitive markets, he adds, “but railroads aren’t competitive markets in the traditional sense.”

Barclays’ analysts “couldn’t disagree more” that comparisons are fatuous between the different North American geographies, likely setting us up for a proxy season of detailed arguments about railroad metrics (having joined Activist Insight a year after the CP proxy fight, I suppose I was cheating fate to avoid it). In a note responding to the news, Barclays analysts said CSX could achieve a 60% operating ratio, down from its current 71%. The upside for the stock in that scenario, they said, could be as much as 47%.